Sunday, October 16, 2011

This post follows from comments in the previous post, where the need arose to explain further what Tom Hickey termed in his comment as net financial assets. What Tom means with 'net financial assets' is net private sector savings, which can offset net private sector debt. That phrase means it is money that people can actually spend, not the meaningless generic term 'money' which can pertain to paper that no one owns or can spend. Both the monetarist concept of M and Tom's definition are part of what money is. M focuses on its changing quantity, Tom focuses on where it comes from. 'Net financial asset' seeks to distinguish how that specific money came about, because some are borrowed into existence, some are government spent into existence. Net financial assets are 'money' the private sector has that was government spent into existence. In our times of high debt, and debt deleveraging, it's also now very important to know how money comes about. Is it borrowed, or printed into existence, or is it structured synthetically? That way you know if that new money is increasing your savings, sinking you in debt, increasing or taking away from your future earnings, will rip your face off, or will blow the whole system up.

Government spending in itself creates the income that the private sector can use to buy government bonds. Put another way, the government's act of using private capacity can create the income that the private sector can use to buy government's borrowing that "funds" the spending (a circuitous process that seems to end up a wash, but with a corresponding higher net financial asset for the private sector). This income from government spending, which becomes 'net financial assets' can then be used by the person who receives it to purchase goods and services from another private person, transferring to that person the 'net financial asset' that he can use to buy other goods and services that he may require. "Net financial asset' then is what enables the private sector to increase aggregate demand without the corresponding liability of paying back that source of purchasing power.

In this system, net borrowing by the private sector is not the most powerful mechanism of increasing money supply or increasing aggregate demand, government spending is. Because the fiscal multiplier effect gave people income, they do not have to borrow the money from the bank anymore to get cash. If you have income from selling to your service to the government, or by selling it to someone who sold his service to the government, neither one of you have to go and borrow the money from the bank to buy your goods and services. The money supply increased without further borrowing. The private sector sold more goods without anyone going into debt.

What happens for example when everyone in the private sector who earned income via the multiplier effect of the fiscal spending suddenly simultaneously decide to withdraw their money from the bank? The bank gives them their money. The money comes from their deposit holdings in the bank, and not as borrowings from the bank. If they withdraw their deposit from the bank, the bank also doesn’t have to borrow it elsewhere. The bank already has the money because the people already put it there (when they earned the income or accumulated the 'net financial asset'), or someone else paying for their service put the money in their deposit. The only time the bank has to borrow the money withdrawn elsewhere is if it already lent that money money elsewhere, and needs the reserves to pay it back. If it’s a deposit, it’s already a deposit. And should the bank ever need the excess reserves to pay back an excess of demanded deposits, where does it get the money/reserves? It gets it from the government/Fed. That's a loan the banks can pay back once they accumulate back the deposits from the people after this roundrobin of withdrawals and redeposits.

Where did the money come from that the government is able to borrow? Monetarists and quasi-monetarists say that for every borrower there is a lender. Monetarists would even say that government deficit does not increase money supply, and government borrowing only crowds the private sector our of being able to borrow that same stock of money. So if the money the government borrows was, as monetarists say, already just sitting idle in some deposit accounts in the private sector, then what gave rise to that private sector deposit? Somebody else borrowing to give that depositor his money? So how is that borrower then getting the money to be able to pay back his own loan? From a further third person borrowing it as well? And how is that 3rd person getting the money to pay back his own loan? This question can go on to infinity. It doesn't make sense to insist that people in the private sector borrowed into existence all the money that the government then afterwards borrowed from them.

If it is true that only bank lending can increase the money supply and government deficits only shifts money from the private sector the government, how would you explain government borrowing rising to the current level it has, $15 Trillion and counting? How is government able to build today’s massive infrastructure projects when at the very beginning, it started off with just 1776 money supply? Where did those trillions of additional money come from? Where did that money come from? Is all of it private bank created? So people are in the hook to pay it all back to some private banks? How did private banks ever get the balls to lend private people, who cannot manufacture money but have to earn it, those trillions of money that just ended up being used to finance government borrowing? More importantly, when the private sector is in balance sheet recession, it would be very erroneous to think that the private sector is the source of government borrowing. At any price. You think you can offer a high enough interest rate to induce folks currently on food stamps to buy more government bonds? What about businessmen now losing sales, what interest rate will make them buy up more bonds? How about those with negative equity, how much you think you can sell to them if we double the current rate?

In that view of the world where every circulating money came from a bank loan, everything will crash one day. That’s an inevitability, because eventually, in that view of the world, people will never earn enough to pay back the loans plus the interest. That world, if it were the real world, is a ticking time bomb one day bound to collapse, when the last person who borrows money decides not to pay the second last person to borrow, and so on. Everything in this view of the world will come crashing down when that day comes, and all it takes is a few unscrupulous people to untangle that ponzi scheme. And once indeed this ponzi scheme stops, how will the system ever get back to work? No one in the private sector can start the process again without having to borrow what he spends. If the government were to be timid to increase spending when private sector stops spending, because of the notion that 'the law forbids anyone or any entity from spending first before funding', then it's game over.

It also doesn't make sense to reform this view of the system by mandating that banks only loan the deposits that they already have. In this scenario, no new money will be created at all. If bank lending were limited to deposits, all loans will have to be callable at any time when the depositor demands his money back. It would be wrong again to assume that since for every borrower, there is a lender, those who would have been lenders just need to start the spending process. Who are these net lenders? Aren't these mostly banks who are in the business of lending, and not of spending? if they cannot make any new loans, they go out of business. And I wouldn't put much confidence either in non-bank private sector people who are hoarding money to re-start the spending process.

I've always wondered why many so-called free market thinkers are monetarists. Just because monetarism enables certain capitalists to make money regardless of what happens to the real economy doesn't mean monetary policy assists in attaining a really free market. Monetarists justify the power of monetary policy via its ability to instil 'animal spirits' or confidence in the private sector. Because the central bank is lowering interest rates or increasing money supply, they believe that that is enough to instil confidence. But increasing money in itself doesn't necessarily mean it increases people's income, or 'net financial assets'. Because the only transmission mechanism that enables this increased money to go from the banks (which are the only entities that deal directly with the central bank) to the people who will actually use it is more borrowing, increasing money supply does not necessarily lead to increased demand. How common is it for example for the fed to buy treasuries from the non-bank sector?

Society doesn't become more confident without an increase in what Tom calls 'net financial assets'. Without this, there'll be no increase in aggregate demand. Without increasing demand, there's no increasing aggregate sales, and no additional borrowing. It's as simple as that. Confidence by itself is just hot air. Inspiring market confidence by itself does not make dollars magically appear in someone’s bank account. Neither does it make someone who didn’t have an iota of cashflow any more creditworthy.

12 comments:

I must clarity that the term "net financial assets" is not my term. It is a key term of Modern Monetary Theory (MMT).

MMT emphasizes the distinction between vertical, "outside," or exogenous money creation by the government as currency issuer, and horizontal, "inside," or endogenous money creation by bank lending.

When banks lend, loans create deposits, which are withdrawn and spent into the economy. Loans are booked as bank assets and deposits as bank liabilities. The net is zero. No net financial assets are created when banks lend. What is created, however, is an interest obligation that exceeds the value of the loan, which must be repaid in addition to the principle.

Conversely, when government deficit spends it creates financial assets in the private sector. These financial assets have no liability in the private sector, so they are non-government net financial assets. The net financial assets injected by government come with no interest payable by the recipient.

This is the basis of the vertical-horizontal distinction that MMT draws, and it is why the government as household analogy is erroneous. Households, firms, and states in the US are currency users, while the federal government is the currency issuer. Missing this distinction is the reason for a lot of junk economics.

A government that is the monopoly provider of a non-convertible floating rate currency is not operationally constrained because it funds itself with currency issuance. Such a government does not tax to fund itself and it does not borrow to finance itself. A currency issuer does not need to get money elsewhere. It issues it.

Taxes withdraw net financial assets previously injected by deficit expenditure. Governments withdraw some of the NFA through taxation for two reasons. First, taxes create a need for the government's money, which Warren Mosler calls a tax credit. This gives value to otherwise worthless pieces of paper. Secondly, governments withdraw NFA from non-government to regulate inflation.

Government does not usually withdraw the total net financial assets it injects. Historically, the US government has generally run a deficit. Only once was the national debt paid down.

The residual of deficit spending is the "national debt." It should be obvious from the above that the "national debt" is actually savings of NFA held by non-government, accruing interest that is also created by currency issuance and adds NFA. All the brouhaha is complaining about growing national wealth in the hands of non-government. Does that complaining make sense?

IN the MMT macro view and policy recommendations based on it, fiscal policy — injection and withdrawal of non-government NFA — is used to adjust nominal aggregate demand to nominal aggregate supply at full employment with a view toward achieving full employment and price stability. In this regard, MMT holds that fiscal policy based on "functional finance" is superior to monetary policy, since it can be adjusted to changing non-government desire to save in order to ensure that the balances of the sectors — government, domestic private, and external — sum to zero at full employment.

Thanks Tom, for the added explanation. I thought people need a long-winded explanation on what is really meant by net financial assets, lest more people get confused by monetarist claims that only the private sector can make money, while government spending cannot. I'm somehow beginning to believe that the best way to get this error out of the public consensus may be to do away with government borrowing. Paying interest on the borrowing only makes the increasingly few who end up with all the hoarded money even richer, rewarding the hoarding. If it were not only for regular people who also have pensions dependent on the existence of government bonds, we would actually bring voice to it.

Tom: "It should be obvious from the above that the 'national debt' is actually savings of NFA held by non-government..."

It probably SHOULD be obvious, but it is not. Why do you say it is "savings"? When I get paid, I spend most of that money and save very little. I think that's true for most people. And so I think it must also be true for people whose income comes from the government deficit spending.

Thanks Arthurian. The savings Tom refers to is aggregate savings, not individual. When the government net spends (therefore accumulates national debt), the private sector receives more income coming into it than going out (out because of tax or bank debt payments), and hence, accumulates net financial assets (NFA). At the individual level, maybe some people are not accumulating savings at all because the NFA, once it circulates via a few individuals, eventually stops short at the hoarder with the best developed method of sucking up the NFA, likely a big capitalist. Ideally, people are spending what they earn to provide income to someone else. Whenever more people are trying to save, less of the NFA moves around, and either government has to spend more, or there will be people who won’t actually get a taste of that NFA.

Since the USG borrows as much money as it spends in excess of tax receipts, its spending does not alter anyone's "net financial assets."

All that has happened is that folks have traded the savings they held in the form of demand deposits at their banks for an identical amount of savings which they now hold in Treasury bills, notes, or bonds.

Ellen1910: All that has happened is that folks have traded the savings they held in the form of demand deposits at their banks for an identical amount of savings which they now hold in Treasury bills, notes, or bonds.

No. Quite wrong. What happens is that folks (in aggregate) KEEP their demand deposits & receive a new amount of savings printed out of nowhere - the deficit - the "borrowing" - held in Treasury bills, notes & bonds. You are doing the accounting wrong, skipping steps, or using inconsistent definitions here & in your earlier posts.

Side point: What is called government "borrowing" is in no way, shape or form borrowing. It is a completely different operation. If one must use the word "borrowing" it is more logical to apply it to government spending.

The usual MMT story: When the USG deficit-spends, it prints a lot of new dollar bills & spends them. (Say it keeps the old bills it received in taxation & spends them, instead of shredding & printing new ones. Obviously "taxed&spent" dollars won't change aggregates - you only need to trace the "new" dollars' course. Or just say taxation is zero.). The new dollars go through the banking system & then the USG prints a lot of bonds which it trades for the new dollar bills, the new reserves the banks hold. The USG then shreds the dollar bills; it'll just print them as needed at the start of the next cycle.

But you can start the cycle anywhere. The following might be more congenial. No Treasury currency-printing & shredding, just bond-printing. Say the USG prints a bunch of bonds. When it "borrows", it gets dollar bills for them & gives the public bonds. But then the USG spends the just-received dollar bills - which go back to the demand deposit accounts & the banks reserves, KEEPING them at the SAME level.

MMTers like to say bond sales are nothing but a reserve drain, to counter government spending. But you might as well say government spending is nothing but a tool to keep reserves, bank accounts up at the same level, to counter the bond-sale reserve drain.

Net result in either case - USG has no more money - why on earth would it save its own money??!! - and the public has the SAME amount of dollar bills & some nice shiny new bonds, which become dollar bills in due course.

Dollar bills & Treasury bonds - are both the same kind of thing - NFA, government debt. It is idiotically simple once one understands it. Modern finance is no different from a game of Monopoly or a medieval king minting coins. Increase in the amount of coins the subjects hold = amount minted & spent - amount taxed. Nongovernment savings = government deficit.

Monkeying around with interest rates & giving a vig to the banksters is a nice side effect, but the whole point of the bonds & reserves etc legerdemain is to disguise the utter, childish simplicity of what is happening. To fool people into having the incorrect belief you concisely expressed.

"Put another way, the government's act of using private capacity can create the income that the private sector can use to buy government's borrowing that funds the spending."

the private sector buying government bonds doesn't "fund" the government's spending. So I don't think this is an accurate statement. I am not sure if you are referring to primary dealers or not...if you are it is unclear and also it should be pointed out that primary dealers are an unnecessary element to our economy altogether. I am not sure what exactly you are referring to in this quote though.

Thanks Mario, you're too kind. As to that phrase, what I was getting at is that it is government spending itself which enables the private sector buy the bonds that we think "funds" the borrowing the government has to make in order to close the deficit. So it's a wash as Ellen says, but a wash that has resulted in a higher net financial asset level for the private sector.

Even though I'm using MMT paradigm i still sometimes slide down to neoliberal terminology. Have to be careful about that as sloppy wording is what gets people thinking about the old paradigm. I have put " " to the word fund in the post.

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"Conventional approaches, unconventional conclusions" on the global finance and economic issues of the day. Rogue Econ has been a banker and financial consultant in several countries. Welcome to my blog.